IMMUNIZATION

ALM

IMMUNIZATION

Immunization of a portfolio:

strategy such that the acquired value of the portfolio is

greater or equal to a given value,
Bond portfolio have an assured return for a specific
time horizon irrespective of interest rate changes

Given value: acquired value of the initial portfolio

with the initial yield to maturity.

ALM

ALM: net asset (assetliabilities) is

protected against interest rates
fluctuations.

1. PORTFOLIO IMMUNIZATION

1.1. Decomposition of portfolio risk

Reinvestment risk

Portfolio value risk

Coupons are reinvested as a rate unknown

Return of an investment depends on the
reinvestment rate.
Prices of bonds vary with interest rates.

If interest rate changes, effective return is

different of yield (expected return).

Steps to compute effective

returns

Compute the acquired value, at the

market rate, of coupons at the horizon
date,
Compute the expected price at the
horizon date,
Compute effective return

Example

Bond B1 (5000, 10%, 4 years, Duration:

3.5 years)
Market rate: 8%, so bond price is 5331.
Just after you buy bond B1 market rates goes
to 7%, 9 %.
What is the effective return of your
investment:

Is sold just after the second coupon,

Is kept until maturity,
Is kept during the time of duration.

Example (solution)

differences between gain and losses

Market rate 7%

Market rate 9%

2 years
Acquired interest
Bond price
TOTAL
Effective Return

1 035
5 271,20
6 306,20
8.76%

1 045
5 087.96
6 132.96
7.26%

4 years
Acquired interest
Bond price
TOTAL
Effective Return

2 219.97
5 000
7 219.97
7.88%

2 286.56
5 000
7 286.56
8.125%

3,5 years
Acquired interest
Bond price
TOTAL
Effective Return

1 662,76
5317.05
6 979.81
8%

1 711.22
5 268.04
6 979.26
8%
7

Comments

Two different effects of rate variations.

If interest rate increases (decreases)

An increase (decrease) of reinvestment of

coupons,
Decrease (increase) in the selling value of
the bond.

At duration time, this two effects

compensate exactly.
8

1.2. Immunization

IMMUNIZATION THEOREM: To
immunize a portfolio duration must be
maintained equal to the remaining
maturity of the portfolio (Fisher et Weil,
1971).

Example

You want to secure an amount of

$1851=1000*1.08^8 in 8 years.
The current yield to maturity is 8 %.
Compare the 2 strategies:

Buy a bond of maturity 8 years,

Buy a bond of duration 8 years (maturity 10
years).

At the end of Year 4 the yield go from 8% to

6%.
Give the value at the end of year 8 with the

10

Example (solution)

80+80*
1.08

Year
1

CF
80

Reinvestt
Rate
0,08

2
3

80
80

0,08
0,08

166,40
259,71

80
80

0,08
0,08

166,40
259,71

4
5

80
80

0,08
0,06

360,49
462,12

80
80

0,08
0,06

360,49
462,12

6
7
8

80
80
1080

0,06
0,06
0,06

0,06
0,06
0,06

569,85
684,04
1841,75

80 1080
80

1.06 1.06 2

End
Value
80,00

CF
80

569,85
80
684,04
80
1805,08 1117

Reinvestt
Rate End Value
0,08
80,00

80

0,06

1080

0,06

11

Immunization is a complex
strategy

As with the passage of time, duration of the

portfolio decrease, the portfolio must be
rebalanced periodically (see case study 1).
The portfolio must also be rebalanced when
interest rate changes.
To avoid the change of shape of the term
structure, you must use bullet portfolio
(bonds with maturity 7 to 9 years to
immunize at 8 years).
12

1.3. Contingent Immunization

Contingent immunization consists of identifying

both:

the available immunization target rate,

a lower safety net level return which a client would
be minimally satisfied or a minimum required rate
of return.

The manager:

Pursues an active strategy until the available

potential return is driven down to the safety net
level,
Completely immunizes the portfolio and lock in the
13
safety net return.

Example

An investor is willing to accept a 6%

return over a 5-years investment
horizon. It is the safety net. Initial
portfolio:$ 100 millions
The possible immunized rate of return
is 7.5%.
The difference between 7.5% and 6%
is called the cushion spread.
14
This cushion permit active

Example (follow)

Compute the required terminal value (at the safety

net rate) of the portfolio assuming semi-annual
compounding.
What is the value of assets required now (at the
current available return) to obtain the required
terminal value? Deduce the safety margin in dollars.
Assume the yield decreases to 5.6%, the market
value of the portfolio increases to $127.46 millions,
give the new safety margin.
Same question if yield increases to 8.6% and
portfolio value decreases to $88.23 millions.
15

Example (solution)

Required terminal value is:

100(1.03)10 = $134.39 millions
Required asset at the current rate
X(1.0375)10 = $134.39
X = $93 millions
Safety margin = 100 93 = $7 millions.
16

Example (solution)

Asset value required to achieve the

required terminal value if current rate is
5.6%:
X(1.028)10 = $134.39
X = $101.96 millions
New safety margin:
127.46 101.96 = $25.5 millions
17

Example (solution)

Asset value required to achieve the required

terminal value if current rate is 8.6%:
X(1.043)10 = $134.39
X = $88.21 millions
New safety margin: 88.23 88.21 = $0 million
At this yield level the immunization mode will
be triggered with an immunization target rate
of 8.6%.
The yield at which the immunization mode
becomes necessary is called the trigger point.
18

2. ALM

Methods and strategies to measure and

manage risks due to the differences
between assets and liabilities
characteristics.
Difference in:

Amount,
Date,
Risk (interest rate but also liquidity,
exchange rate risk)

19

Objective of ALM

Protect equity (more generally surplus,

a stock) = Value of assets value of
liabilities
Protect an income (earnings, cash flow,
interest margin, a flow).

20

2.1. Cash flow matching

(CFM)

Construct the liabilities schedule.

Construct an asset portfolio that
reproduces the liabilities schedule.
Objective: minimize the investment in
the asset portfolio.

21

Process for CFM

Method of matching by bonds of decreasing maturity

Step 0: construction of liabilities cash flows
Step 1: choose a bond with a maturity equal to the
last flow of liability, lets say, T. Compute the number
of bonds necessary to match this flow.
Step 2: compute the remaining liabilities cash flows
after deducing cash flow of the first bond.
Step 3: choose a new bond with maturity T-1.
Step 4: compute the remaining liabilities cash flows
after deducing cash flow of the second bond
And so on untill the shortest maturity of liabilities.
22

Example

You must cover the following liabilities

schedule.
Years
1
2
3
4
5

Liabilities
1 000 000
1 000 000
1 000 000
1 000 000
1 000 000
23

Example
Bond available
All bonds have a nominal of
maturity
coupon
B1
5
3%
B2
4
5%
B3
3
4%
B4
2
6%
B5
1
3.50%

100
Price
99.32
106.84
102.65
109.25
100.22
24

Work to do

Give the asset portfolio structure

matching liabilities. (cash flow
matching).
Give the value of asset portfolio.

25

Liabilities

O1

L1

O2

L2

O3

L3

O4

L4

O5

L5

1 000 000

29 127

970 873

46 230

924 643

35 564

889 079

50 328

838 751

838 764

-13

1 000 000

29 127

970 873

46 230

924 643

35 564

889 079

889 128

-49

-49

1 000 000

29 127

970 873

46 230

924 643

924 664

-21

-21

-21

1 000 000

29 127

970 873

970 830

43

43

43

43

1 000 000

1 000
027

-27

-27

-27

-27

-27

Nber of
Bonds

maturity

coupon

Price

B1

3%

99.32

103

9709

B2

5%

106.84

105

9246

B3

4%

102.65

104

8891

B4

6%

109.25

106

8388

B5

3.50%

100.22

103.5

8104

Portfolio Value

4 593 373.55

FT

26

Cost/benefit of CFM

Benefit:

Drawback:

Totally suppress risk,

Asset portfolio does not need to be rebalanced so
transaction costs are low.
It is not always possible to construct an asset portfolio
perfectly reproducing liabilities schedule.

Less demanding method:

To construct a portfolio such that acquired value of

Asset is greater than acquired value of liabilities.
Problem: reinvestment risk for cash flows of asset and
liability.
27

More Technical Aspects (Kocherlakota,

Rosenbloom, Shiu, 1988)
Nber of bonds j
to buy

Price of
bond j

Min N j P j
j

Cash flow in t
of liability

constraint s

N j C t , j L(t )
j

N j 0

Cash flow generated

in t by bond j
28

2.2. Duration matching

Objective: to protect the surplus of a

company.

DA A DE E DL L
DE E DA A DL L 0
DA A DL L
29

Example: life insurance company

Assets (investment on the market): 100

Duration: 7 years
Liabilities: 80
Duration: 15 years
Give the variation of equity value when
interest rate decreases from 5% to 4%.

30

7
0.01100 6.67
dA
1.05
15
0.01 80 11.43
dL
1.05
Loss in equity val ue : 4.76
Immunizati on :
L
DA DL 12 years
A
12
0.01100 11.43
dA
1.05
31